Organigram: Operating In A Structurally Challenged Industry

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Organigram Holdings Inc. is a leading producer of medical and recreational cannabis products in Canada.The cannabis industry faces structural challenges, including low gross margins and intense ...

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David Trood/DigitalVision via Getty Images As a Canadian investor, one of my biggest regrets in the past decade has been not buying into the Great Canadian Cannabis hype cycle in the 2010s. Many fortunes were made in the sector, as early investors saw 10x-20x gains. One of the cannabis stocks that I missed out on was Organigram Holdings Inc. (NASDAQ:OGI). Measured from June 11, 2015, when the Supreme Court of Canada released its landmark decision allowing private individuals to possess marijuana and its derivatives without risk of prosecution, Organigram's stock rallied more than 2,400% to its peak in 2019 at over C$45 / share (Figure 1). Figure 1 - Organigram was a 24-bagger at one point (Stockcharts.com) However, cannabis stocks also fell precipitously in 2019 and 2020 in a 'sell the news fashion' after recreational cannabis as fully legalized in Canada and retail stores were inaccessible due to the COVID-19 pandemic. In early 2021, cannabis stocks staged an impressive rebound as retail stores re-opened and investors were hungry for high-risk/high reward opportunities. Unfortuantely, once the equity markets turned lower in 2021, cannabis stocks have also been some of the worst performers in the market, with OGI declining almost 95% from its peak to a recent price of C$2.58 / share. If we map the rise and fall of OGI's stock price to the classic asset bubble pattern, we can see that 2019 and 2021 were the model definition of \"New Paradigm\" and \"Return to Normal\" (Figure 2).  Figure 2 - Illustrative pattern of asset bubbles (pilotwm.com) Similarly, the declines since 2021 has been akin to the \"Fear, Capitulation, and Despair\" phases of the cycle. The question now is whether we are in the \"Return To The Mean\" phase, where burst-bubble stocks transform into solid long-term investments after all the hype and despair has been washed out. Unfortunately, my analysis of the cannabis industry and Organigram does not give me confidence to recommend the stock yet. In my opinion, the cannabis industry is too competitive with undifferentiated products for participants like Organigram to earn their cost of capital. Therefore, I rate Organigram a hold for now. Brief Company Overview Organigram was incorporated in 2013 and became a licensed producer of medical marijuana in Canada in April 2014. The company listed on the Toronto Ventures Exchange via a reverse takeover in August 2014.  Once recreational marijuana was legalized in October 2018, Organigram has also become one of the largest producers and retailers of recreational cannabis products in Canada. The company's product portfolio includes brands targeted at all niches of the market including Value, Mainstream, Premium, and Craft in terms of price point, and whole flowers, hash, pre-rolls, vapes, and oils in terms of product categories (Figure 3). Figure 3 - Organigram owns brands across all market niches (OGI investor presentation) Organigram's production is primarily conducted in three state of the art facilities including a large indoor growing facility in Moncton, New Brunswick with capacity for 85,000 kg/year of various flowers; a 51,000 sq. ft. edibles factory in Winnipeg, Manitoba; and a craft-growing greenhouse in Lac-Superieur, Quebec (Figure 4). Figure 4 - OGI facilities overview (OGI investor presentation) Financials Have Been Lacking In my opinion, the number one factor in determining whether a company is a viable turnaround candidate is to look at the company's financials. For long-term investments, I want to see growing revenues, margins, and earnings.  Unfortunately, OGI's financials do not paint a pretty picture. First, for a supposedly new industry, Organigram's recent revenue growth has been disappointing. For example, the most recent Q1/F24 revenue of C$36.5 million was 15.7% lower than Q1/F23 and 8.8% lower than Q4/F23 (Figure 5).  Figure 5 - OGI financial summary (OGI Q1/F24 MD&A) Furthermore, including impairments of inventory (stale inventory) and changes in fair value of biological assets (marking in-production cannabis products to fair market value), gross margin was a skinny 18%, the second lowest margin in the past 8 quarters. Moving on to operating margins and earnings, the picture gets even worse as Organigram routinely spends more in operating expenses than it earns in gross profits. For example, in Q1/F24, OGI spent C$22.6 million in operating expense against just C$6.7 million in gross profits (Figure 6).  Figure 6 - OGI routinely operates in the red (OGI Q1/F24 MD&A) This corporate profligacy has left the company perennially reporting net losse quarter after quarter, year after year. In fact, the only profitable quarter for Organigram in the past few years was in Q1/F23 (Figure 7). Figure 7 - OGI routinely reports net losses (OGI Q1/F24 MD&A)  CPG Giants Waiting In The Wings Against this poor operating background, cannabis companies continue to attract investments from traditonal 'sin' companies operating in the tobacco and alcohol industries, as those mature companies appear star-struck by the 'growth potential' of cannabis. For example, Organigram recently announced the closing of the first tranche of its follow-on investment by British American Tobacco (BTI) for C$41.5 milion (Figure 8). BTI already owns 19.9% of Organigram from an investment made in 2021, and this latest batch of follow-on investments could bring BTI's economic ownership of OGI to a maximum of 45%. Figure 8 - Organigram received a large follow-on investment from BTI (OGI investor presentation) In effect, for a few hundred million dollars in total investment (a drop in the bucket for BTI with $100 billion in enterprise value), BTI has a toehold in the emergy cannabis industry via Organigram. If the industry one day matures into a high profit industry like tobacco, I believe BTI will buyout the remaining parts of OGI it does not already own.  January Was A Poor Start To 2024 Looking forward, January was a poor start for the Canadian cannabis industry, as Statistics Canada saw total cannabis sales drop 11.5% MoM from December to just C$400 million.  Bay Street / Wall Street analysts on average expect Organigram to report a 4% YoY decline in revenues to $28 million for the quarter ended March 31, 2024, and another net loss of $0.06 / share (Figure 9).    Figure 9 - Analysts are expecting a poor start to 2024 (Seeking Alpha) Given the poor national sales trend and lack of cost controls at the company, there is no reason to expect any positive surprises at Organigram. Valuation Is Hard To Gauge In my opinion, Organigram's valuation is hard to gauge. On the one hand, at just $190 million in market cap and $163 million in enterprise value, OGI may appear cheap to the casual observer, trading at just 1.4x Fwd EV/Sales (Figure 10).   Figure 10 - OGI has a low valuation (Seeking Alpha) In fact, on Fwd EV/Sales, OGI is the cheapest out of the top 3 Canadian LPs, Canopy Growth (CGC), Organigram, and Tilray (TLRY) (Figure 11).   Figure 11 - OGI vs. peers, valuation (Seeking Alpha) On the other hand, Organigram does not generate any operating profits, so what is value in OGI's case? If we perform a discounted cash flow analysis on a company that does not generate operating profits, the result is zero.  I believe an investment in Organigram is a bet that one day in the future, the company will scale production and revenues to a level such that its revenues will more than cover its costs with a healthy profit magin. Unfortunately, I fear that day may never come. Cannabis May Not Be A Viable Industry Contrary to popular opinion, I do not believe cannabis is a viable industry, at least not in its current state. In order to be viable, an industry needs to generate a decent level of gross profits such that SG&A expenses can be covered with improving economies of scale. However, if we look at the three largest Canadian LPs, we can see that the cannabis industry leaders all have low gross margins of 30% or less (Figure 12).    Figure 12 - Canadian cannabis leaders all have low gross margins (Seeking Alpha) This contrasts with mature consumer product companies in the tobacco and alcohol industries where gross profits are routinely 60% and above (Figure 13 and 14).   Figure 13 - Tobacco companies have outstanding gross margins (Seeking Alpha)  Figure 14 - As do alcohol companies (Seeking Alpha) Margins Are Structurally Challenged I believe the issue with the cannabis industry is structural. First, let's take a look at Organigram versus its peers, to see if it has any sustainable competitive advantages and/or product differentiation. As we mentioned above, Organigram is one of the largest producers of cannabis products in Canada, competing in all market niches. Unfortunately, that is not a unique business model, as the same can be said for Canopy Growth, Tilray, and all of the top producers. In fact, if we go to the Ontario Cannabis Store (\"OCS\", one of the legal online retailers in Ontario, Canada), we can see that there are over 200 pages and 4,000 individual cannabis products available for purchase (Figure 15).   Figure 15 - Consumers are hard pressed to identify with any particular brand (ocs.ca) A casual cannabis user would be hard pressed to differentiate between products from Organigram vs. any one of the hundreds of other legal producers / brands. Furthermore, not only do leading LPs like Organigram have to compete with each other, they must also compete with black market competitors that may not have the same cost structure as legally licensed producers. In Canada, it is estimated that approximately 40% of cannabis sales still come from the black market. In the U.S., the figure is closer to 75%. With possession no longer illegal, it is often hard to deter activity from the black market, since cannabis products outside of their packaging are virtually indistinguishable between legal and illegal sources. This negatively impacts cannabis selling prices. On the cost side, unlike tobacco and alcohol products which are mostly standardized (i.e. BTI only produces a few variety of cigarettes using the same tobacco leaves and Constellation only brews a few types of beers), the plethora of different strains and THC/CBD levels (see Figure 13 above) means that cannabis companies cannot achieve the same economies of scale enjoyed by the tobacco and alcohol companies. The combination of high costs and low prices means that cannabis margins may be structurally constrained, leading to low profitability for producers and retailers. In fact, according to a BBC article, In 2023, there were around 3,600 licensed retail cannabis stores across the country and 970 licensed cannabis producers in Canad, but a survey by the Cannabis Council of Canada found that only ~20% of the producers are showing some sort of positive cashflow!  Risks To Organigram The risk to being too cautious on cannabis stocks like Organigram is that it is still a nascent industry where the future is uncertain. For example, if the U.S. government finally follows through on its long talked about legalization plans, then just the improvement in sentiment and momentum could propel cannabis stocks much higher. On the other hand, downside risks are also plenty for the company. For example, since Organigram only has 1 primary growing facility in Moncton, if anything were to happen with this facility, then production and revenues may be negatively impacted. Financially, investors also need to monitor the company's balance sheet, as it only had C$42 million in cash as of December 31, 2023 against C$15.8 million in net loss for Q4/F24. Fortunately, cash flow from operations was actually positive C$7.7 million in Q1 on non-cash charges and working capital release. Furthermore, Organigram is on track to receive a total of C$125 million in follow-on investments from BTI over the next few years, so cash should not be a near-term concern. Conclusion Organigram is a leading Canadian producer of medical and recreational marijuana. OGI's stock has closely followed the typical asset bubble price pattern, which suggest we may be finally in the long-term recovery phase after 2022/2023's steep declines. However, I believe the cannabis industry is structurally challenged from high costs and intense competition from both legal and illegal sources. Until the industry changes, investors are unlikely to make money investing in Organigram except during short-term squeezes due to headline catalysts. With respect to Organigram specifically, my concern is that the company sells undifferentiated and commoditized products compared to other cannabis producers, causing the company to receive low gross margins. Until the company can demonstrate an ability to sustainably expand gross margins to > 50% and deliver operating profits, I believe it is only a matter of time before Organigram burns through all of its capital and either goes bankrupt or dilute existing shareholders with capital raises.  Although I believe intrinsic value for OGI is zero (based on its inability to generate operating profits), I would not short the company, as the company's valuation is relatively low and the sector has a history of painful short squeezes. 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